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posted on 22 January 2017

Inflation: The Good And The Bad

by Lance Roberts, Clarity Financial

Since the November election of Donald Trump, the investing landscape has gone through a dramatic change of expectations with respect to economic growth, market valuations and particularly inflation. It is the view of inflation that I want to touch on today as it relates to the belief the "Death Of Great Bond Bull Market" has finally arrived.

The chart below shows the massive surge in inflationary expectations as of late in both the 5-year and 10-year rates as well as the mean PCE inflation rate. (#SarcasmAlert)

As you can see, while expectations of a rise in inflationary pressures have risen since the election, the consumer price index (CPI) was already rising fairly strongly since the beginning of 2015.

So, if the rise in inflation expectations remains muted, what's the reason for the recent surge CPI? That rise can be directly linked to the full onset of the Affordable Health Care Act which sent medical inflation costs surging. This is something I warned about many times in the past.

"The impact of the Affordable Care Act is now taking root. Unfortunately, for many, that impact is not a positive one as surging premiums absorb more of the discretionary budget of households."

The Fed believes the rise in inflationary pressures is directly related to an increase in economic strength. However, as I will explain: Inflation can be both good and bad.

Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices.

That would be the good.

The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.

If we take a look at import and export prices there is little indication that inflationary pressures are present.

This lack of economic acceleration can be seen in the breakdown of the Consumer Price Index below. It can clearly be seen where inflationary pressures have risen over the last 5-months.

(Thank you to Doug Short for help with the design)

As is clearly evident, the surge in "health care" related costs, due to the surging premiums of insurance due to the "Un-affordable Care Act," pushed both consumer-related spending measures and inflationary pressures higher. Unfortunately, higher health care premiums do not provide a boost to production but drain consumptive spending capabilities. Housing costs, a very large portion of overall CPI, is also boosting inflationary pressures. But like "health care" costs, rising housing costs and rental rates also suppress consumptive spending ability.

"For the middle-class and working poor, which is roughly 80% of households, rent, energy, medical and food comprise 80-90% of the aggregate consumption basket." - Research Affiliates

The problem for the Fed is that by pushing interest rates higher, under the belief there is a broad increase in inflation, the suppression of demand will only be exacerbated as the costs of variable rate interest payments also rise.

With households already ramping up debt just to make ends meet, another increased expense will only serve to further suppress "consumer demand."

The Rest Of The Story

As Michael Lebowitz noted:

By narrowly focusing on consumption, economists have lost sight of production. Such disregard for the supply curve is proving to be a costly error.

As monetary policy increasingly encouraged debt-financed consumption, corporations responded by expanding their capacity and operations to keep up with the policy-induced demand for their goods. Both the demand and supply curves shifted in unison, reflecting greater demand and production capacity. Unfortunately, over time, the consumers' ability to take on additional debt has diminished and the demand curve shifted back. The supply curve, however, is less flexible as corporations cannot easily reduce their production capacity. Attesting to this overbuild is capacity utilization which, as graphed below, is trending lower and stands at a level that has been indicative of recessions in prior cycles.

Capacity Utilization

cap-utiz

Data Courtesy: St. Louis Federal Reserve (FRED)

In response to weaker demand, corporations downsized employment, outsourced production and limited wage increases. Partially as a result of their actions, the labor participation rate lingers at 38 year lows and real median wages are at levels comparable to 1998. Corporations created a negative economic feedback loop as their employees are also consumers of their products.

Another unfortunate consequence of weaker demand is that instead of investing some profits towards productive activities, a majority of corporate cash flows have been diverted to shareholders to engineer better financial ratios and earnings per share to help compensate for weakening sales. The results may be optically appealing and supportive of equity market valuations in the short-term, but these decisions are decidedly not constructive for the long term health of the corporations and the economy.

The bottom line is that disregard for production oriented aspects of the economy (the supply side) and myopic over-emphasis on debt-financed consumption (the demand side) naturally limited potential corporate and national economic growth.

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens" - John Maynard Keynes


So...What's Driving Rates?

"If inflation, outside of healthcare and rent, isn't really an issue then what's been pushing interest rates higher over the last couple of months? "

Good question.

Here's the short answer:

"Rates Are Rising Because Of China, Not Inflation"

Let me explain.

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to last year. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (You have to kind of squint to see it.)

interest-rates-then-and-now-121316

While the bump in rates has been fastened to the recent election of Donald Trump, due to hopes of a deficit expansion program (read: more debt) and infrastructure spending which should foster economic growth and inflation, it doesn't explain the global selling of U.S. Treasuries.

bonds-foreign-holdings-121316

For that answer, we only need to look at one country - China.

It is important to understand that foreign countries "sanitize" transactions with the U.S. by buying treasuries to keep currency exchange rates stable. As of late, China has been dumping U.S Treasuries and converting the proceeds back into Yuan in an attempt to stop the current decline.

The stronger dollar and weaker yuan increase the costs of imports into China from the U.S. which negatively impacts their economy. This relationship between the currency exchange rate and U.S. Treasuries is shown below. (The exchange rate is inverted for illustrative purposes.)

china-holdings-bonds-exchangerate-121316-2

The selling of Treasuries by China has been the primary culprit in the spike in interest rates in recent months. As I will discuss in a moment with respect to the trade deficit, there is little evidence of a sustainable rise in inflationary pressures. The current push has come from a temporary restocking cycle following a very weak first half of the year economically speaking, and pressures from higher oil, health care, and rental prices.

As noted by Horseman Capital in their recent note to investors (Via Zerohedge):

"Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed US bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has been one time when this relationship has broken down. In 2007 and 2008.

Today we are seeing the reverse, I believe. The Chinese financial system is showing signs of stress. Corporate bond yields are rising, the Chinese Yuan is weakening, and outflows are continuing. In my view, the Trump election has made a large Chinese devaluation more likely. Mainland Chinese investors are desperately trying to get out of the Yuan, and the People's Bank of China is trying to defend the value of the Yuan. They are doing this by selling treasuries."

This is shown, the annual rate of change in U.S. bond holdings by China is rapidly approaching historical lows (axis is inverted).

china-chginholdings-rates-121316

"The problem with this is that the more treasuries the PBOC sells, the more yields are likely to rise, putting more pressure on the Yuan. It seems to me that the PBOC is stuck in a doom loop. But as I noted in my market view, the PBOC is running out of options.

In my view, the macro model that I have been using to think about markets still looks valid, despite recent moves. The model indicates that it is impossible for countries that have engaged in QE to then normalize interest rates without causing financial crises with their trade partners. Since 2013, we have had the taper tantrum, devaluations in India, Russia, and Brazil, which all helped to drive long dated treasuries to new lows. Now the market is thinking the US will normalize rates, and the second biggest economy in the world is struggling. A rerun of 2007/8 is looking likely to me." - Russell Clark, Horseman Global

While much of the mainstream media continues to protest the "Great Bond Bull Is Dead," as expectations rise for a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then population, wage and consumer debt growth become key inputs into that equation. Unfortunately, with wage growth stagnant and on the decline, population growth weak and consumers already extremely leveraged, a surge in economic growth to sustain higher interest rates is highly unlikely.


The Tailwind For Bonds

As explained, my case for interest rates is lower rather than higher. China's selling will eventually abate as either they run out of Treasuries to sell or they stem the tide of the currency decline. Furthermore, economic weakness will likely reassert itself this year as a recessionary spat approaches pushing rates lower.

Regardless of which occurs first, the setup for a push towards 1% on the 10-year Treasury, or lower, is already baked into the cake. As my friend Dana Lyons pointed out this past week:

"As one might imagine, the collapse in bond prices has had quite an impact on traders' sentiment and positioning. In fact, if we shift to the 10-Year T-Note futures market, we find that Speculators have pulled a 180 and now hold their largest net-short position of all-time - by a lot. At a net-short position of nearly 400,000 contracts, it is more than 100,000 larger than any other in history."

If the market corrects, OR the economy hits a speed bump, OR something happens in the Eurozone, OR...OR...OR...the covering of short positions in bonds will cause an extremely fast drop in yields.

Sure, anything can happen. If yields on the 10-year Treasury break above 3% it will be coincident with a sharp rise in consumer spending, wages, inflationary pressures that are broad based and surging economic growth. In such a case it will make sense to reduce bond holdings in favor of equities.

However, given the fact we are already in the 3rd longest economic expansion in history, combined with the second highest levels of valuation on stocks, the odds of such an outcome are extremely low.

I remain long bonds as a hedge against my long equity exposure.

#PortfolioHedgesMatter

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